Traders and investors who desire to buy or sell securities place orders with brokers who trade on the floor of organized stock exchanges—such as the New York Stock Exchange (“NYSE”) or the American Stock Exchange (“Amex”)—they send orders to over-the-counter (“OTC”) market-makers trading on the NASDAQ market, and they utilize crossing networks, electronic communications networks (“ECNs”), and other electronic trading systems, such as Reuters' Instinet®, ITG Inc.'s Portfolio System for Institutional Trading (POSIT®), and Optimark Technologies, Inc.'s OptiMark™. While many exchanges and electronic trading systems offer broker-dealers and institutional investors (collectively, “institutions,” “institutional investors,” “institutional clients,” “professional market participants,” and “professional investors”) the opportunity to trade, directly or indirectly, with other professional market participants, these trading venues either completely disallow or severely curtail opportunities for efficient interaction between institutional orders and many of the orders generated by retail investors. Specifically, while institutional investors participating in markets which receive retail order flow can often interact with retail non-marketable orders, the opportunity to interact with retail marketable orders either does not exist at all (for reasons identified below) or requires the manual services of a human broker, rendering the process so cost-prohibitive as to make it impractical for professional market participants interested in sustained interaction with these orders. “Retail marketable orders” consist of post-open market orders and marketable limit orders (that is, buy limit orders priced at or above the current best offer, and sell limit orders priced at or below the current best bid), which are generally executed immediately at prevailing best bids or offers. “Retail non-marketable orders” consist of all other order types—for example, pre-open orders (that is, orders entered outside normal market hours), non-marketable limit orders (that is, buy limit orders priced below the current best offer, and sell limit orders priced above the current best bid), market-on-close orders, and so forth. Retail non-marketable orders are typically not subject to immediate execution.
In the case of non-exchange-listed (that is, NASDAQ) securities, and of exchange-listed securities traded in the OTC market (that is, “Third Market” securities), both retail marketable orders and retail non-marketable orders have historically been executed by OTC market-makers acting in a principal capacity pursuant to order-routing and remuneration arrangements with retail brokerage firms, or they have been “internalized” by retail brokerage firms routing these orders to specialist or dealer affiliates which execute them in a principal capacity. Regulatory changes enacted by the Securities and Exchange Commission (SEC) in recent years have made it possible for some of these orders to interact with trading interest other than that of the market-maker or dealer to whom they were routed for execution. Specifically, the SEC now requires market-makers (as well as exchange specialists and other dealers) to (1) display certain customer limit orders in their public quotations, where they are visible to, and sometimes accessed by, other market participants, and (2) desist from “trading ahead” of unexecuted orders in their possession by buying or selling any security as principal at a price which would satisfy an unexecuted customer order in that security. However, while these regulations sometimes result in retail non-marketable orders being executed against retail marketable orders or against trading interest from other professional investors, it remains the case today that retail marketable orders received by OTC market-makers and other dealers are rarely, if ever, available for execution against the trading interest of other professional market participants.
In the case of exchange-listed securities executed on the NYSE or Amex, interaction between the large, generally block-size, orders of professional market participants (which are typically greater than 10,000 shares in size) and retail marketable orders is theoretically possible, but requires the services of a human floor broker, who must physically stand in “the crowd” at the trading post for a security on the exchange floor in order to compete with the public limit order book and other floor brokers for the opportunity to interact with incoming retail marketable orders on the opposite side of the market. It should be noted that the only strategy for interaction with retail marketable orders on the exchange floor available to professional market participants that does not require the services of a floor broker involves the placement of large, publicly displayed limit orders. Because such orders often result in highly adverse market impact to the market participant placing the orders, they are impractical as a mechanism for interaction with marketable retail orders and are therefore never utilized for this purpose. In the absence of extant or expected block-size contra trading interest by another broker, floor brokers working large orders are generally not willing to stand at a trading post on the exchange floor for an extended period solely to compete for small retail marketable orders. Thus, while it is possible in theory for a professional market participant to interact at favorable terms with individual retail marketable orders on the floor of the NYSE or Amex through the services of a human floor broker, there is currently no automated or cost-effective way to accumulate large aggregate positions over an extended period by interacting with hundreds or thousands of small retail orders.
Although they are individually small (about 600 shares in size, on average), the trades of retail investors represent a potential source of substantial aggregate liquidity—approximately 40% of total share volume in NYSE and NASDAQ issues is retail, and approximately 50% of retail orders in NYSE and NASDAQ stocks are marketable. Moreover, because the relatively small marketable orders placed by retail investors generally result in negligible market impact, or price slippage, and are typically information-less (that is, the orders are not normally motivated by informed predictions regarding short-term price movements), they are highly attractive to professional market participants as a source of liquidity for securities transactions. However, given the above described limitations on: (1) simple access to retail marketable orders (as, for example, in the case of internalized orders or orders routed to OTC market-makers for execution); and (2) efficient access to such orders where simple access is not structurally disallowed (as, for example, on the floor of the NYSE and Amex), a crossing network is needed which facilitates continuous, fully electronic, anonymous, automated, and non-display-based interaction between professional market participants and retail marketable orders. Such a network would fill an important niche not only by effectively disintermediating existing specialists and OTC market-makers for many orders (thereby giving other professional market participants the opportunity to interact directly with these retail marketable orders at favorable prices), but also by automating the otherwise prohibitively labor-intensive process of accumulating sizeable aggregate positions via a large number of small transactions with retail counterparts.